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ABSTRACT
Our revisionist
theory of the gold standard takes the bill market and the discount rate into
full account. Greater availability of gold is no cause for inflation. The new
gold flows to the bill market lowering the discount rate, which quickly puts
a greater variety of consumer goods on the shelves of retail shops, thus
preventing prices from rising. Nor is reduced availability of gold a cause
for deflation. The gold is withdrawn from the bill market raising the
discount rate, which quickly eliminates marginal merchandise from the
shelves, thus preventing prices from falling. Rising prices are never the
result of an abundance of gold. They are always the result of scarcity of
goods, such as that caused by misguided credit policies of banks discounting
financial bills not backed by maturing consumer goods. Falling prices are
never the result of a scarcity of gold. They are always the result of an
overabundance of goods, such as that caused by misguided government policies
creating unemployment.
UNEVENLY ROTATING ECONOMY
The
gold standard can only be understood in the context of its clearing system,
the bill market, trading real bills that move in a direction opposite to the
flow of maturing goods to the final gold-paying consumer. Authors looking at
the gold standard in isolation got a cock-eyed perspective. They have to
invoke the quantity theory of money. The trouble is that, although it could
explain linear changes, the quantity theory is helpless to explain non-linear
phenomena such as dynamic changes. Whenever Mises
talked about an “evenly rotating economy,” he was careful to rule
out dynamics. To this extent his opus is incomplete and can only be
finished by extending it to the “unevenly rotating” or dynamic
economy wherein the quantity theory of money no longer applies. The evenly
rotating economy is strictly an abstraction that, by Mises’
own admission, nowhere exists in reality, not even as a first approximation.
CLASSICAL THEORY OF THE GOLD STANDARD
There
is a natural tendency to minimize gold flows across international boundaries.
Typically, balances are settled, not through gold remittances but through
arbitrage in real bills. Arbitrageurs buy bills in a country running a
deficit and sell an equivalent amount in a country running a surplus, to take
advantage of the favorable spread in the discount rate. It is particularly
effective if one country acts as a clearing house, as England has done prior
to World War I.
This
observation invites the following critique of the classical theory of the
international gold standard according to which gold flows from a deficit to a
surplus country, inducing changes in the relative price levels. According to
the quantity theory of money prices are falling in the deficit country and
rising in the surplus country. Higher prices are supposed to have the effect
of discouraging exports while encouraging imports, with the opposite effect
for lower prices. This purports to explain the adjustment mechanism of
foreign trade. However, this pernicious theory has never worked in practice
but it caused a lot of monetary mischief in the world after Milton Friedman
persuaded governments to “float” their currencies in the early
1970's. Friedman’s theory of trade adjustments through currency
devaluation, a variant of the classical theory of the international gold
standard, was an unmitigated failure, although this was never publicly
admitted. If not corrected soon, it will destroy the international monetary
and payments system through competitive currency devaluations and trade wars,
or worse.
REVISIONIST THEORY OF THE GOLD STANDARD
In
reality, the price level hardly ever reacts to trade imbalances. Economists
have been at a loss to explain persistent trade deficits and blamed the gold
standard for the anomaly. They should have blamed themselves and their flawed
theories.
As
our more sophisticated theory shows, if the supply of gold increases in one
country, then the new gold first flows to the bill market where it will bid
up the price of real bills. This makes the discount rate fall. Shopkeepers
respond by filling their empty shelf-space with marginal merchandise. By the
time new gold trickles down to the rest of the economy in the form of higher
wages and greater dividend income, the extra merchandise will be in place
waiting for the increased consumer-spending to materialize. Social
circulating capital expands and soaks up extra demand for consumer goods.
There is no inflation.
Conversely,
if the supply of gold decreases in a country, then the gold is withdrawn from
the bill market against selling real bills. Bill prices fall. The discount
rate jumps. Shopkeepers respond by eliminating marginal merchandise form
their shelves. Neither gold outflow nor increased gold hoarding will squeeze
prices. Instead, they cause social circulating capital to contract and
propensity to consume decline. Marginal merchandise is no longer available in
every grocery store. The consumer who still wants it must search for it in speciality shops and be prepared to pay a higher price
for it since moving these items can no longer be financed at the low discount
rate; it must be financed through a loan at the higher interest rate. There
is no deflation.
Karl
Marx talked about the “anarchy of the market” under the
capitalist mode of production, suggesting that producers act blindly and they
inevitably glut the market through overproduction. But as our analysis
shows, assuming that the discount rate is not distorted by the banks and the
government, producers and distributors have a sensitive inner communication
system, the bill market. They know that by the time the new product reaches
the shelves of the shopkeeper the sovereign consumer will be looking for it.
Producers and distributors get their signals, not from the rate of interest
or prices that are far too sluggish, but from the nimble discount rate. Its
fall is heralding an increase, and its rise a decrease, in consumer demand.
FUNDAMENTAL PRINCIPLE OF RETAIL TRADE
This,
then, is the fundamental principle of the retail trade. The adjustment
mechanism which brings into balance the amount of gold in circulation with
the supply of consumer goods works, not on prices but on the discount rate.
The law of supply and demand is inoperative. An autonomous increase in demand
has no inevitable effect on the prices of consumer goods but will, instead, lower the rate of marginal productivity of
social circulating capital, i.e., the discount rate. The lower discount rate
automatically makes the supply of consumer goods expand.
By
the same token, an autonomous decrease in demand will raise the rate of
marginal productivity of social circulating capital, a.k.a. the discount
rate. A higher discount rate automatically makes the supply of consumer goods
shrink. There is no such a thing as an autonomous change of supply in the
retail trade. Supply is closely regulated by demand through the mechanism of
the bill market and the discount rate.
The
vulgar supply/demand equilibrium analysis fails to describe the process of
supplying the consumer with urgently needed goods. It could not explain why
prices were stable under the gold standard even in the face of great
changes in demand. In a previous article I have explained this phenomenon in
terms of increasing economic entropy.
COPING WITH NATURAL DISASTERS
If a
country is stricken with bad harvest or by some other natural calamity
destroying property and consumer goods, then there will be an immediate increase
in the discount rate. Retail prices of consumer goods will not rise
inevitably. The stricken country, thanks to its high discount rate, is an
attractive place on which to draw bills. This translates into an immediate
influx of short-term credit from abroad in the form of the most urgently
needed consumer goods. In comparison, the present system of politically
motivated trade privileges bungles foreign aid hopelessly. By the time the
amount and kind of aid is agreed upon by the negotiators, the need may have
shifted. The gold standard is by far the best system for international
division of labor, in good times as well as in bad. Governments have exposed
their subjects to unnecessary deprivations when they first sabotaged the
clearing system of the gold standard, the international bill market, and then
destroyed the standard itself. Peoples of various countries will help one
another to the fullest possible extent under the international gold standard,
provided that its clearing system, the bill market, is not sabotaged by the
governments, as it was in 1909 when bank notes were made legal tender in
Germany and France. In the absence of a gold standard peoples are pitted
against one another in a bitter competition and trade wars, often escalating
into shooting wars.
COPING WITH A GOLD AVALANCHE
By
the same token, the international gold standard and its clearing system the
bill market allows nations to share the windfall of a sudden increase in the
world’s stock of monetary gold in a way that rewards the industrious
and penalizes the inept. Let’s assume that the output of gold mines
increases by leaps and bounds, or that foreign gold invades one particular
country. It need not cause an increase in prices, as predicted by the vulgar
theory. Instead, it will benefit all countries adhering to the international
gold standard, through a general lowering of the discount rate. It will first
drop in the country hit by the gold avalanche. Suppliers will start drawing
bills on foreign countries with a higher discount rate. Increased imports
will repel the invasion of foreign gold and expel excess domestic gold.
Social circulating capital expands with the lowering of the discount rate.
The spinoff from higher incomes due to the greater availability of gold will
be met by an expanded offering on the shelves of shopkeepers who are now able
to display a greater variety of goods, thanks to the lower marginal
productivity of social circulating capital. As excess gold is expelled, other
countries will also participate in the windfall. Benefits are by no means
confined to the country where the gold fields are located.
Now
suppose that all countries except one close their Mints to gold, and all the
monetary gold in the world descends upon that country. Even in this extreme case
there is no need for the prices to rise. The rate of marginal productivity of
social circulating capital will be approaching zero. Retail stores will run
out of shelf space and start using the side-walks to display marginal
merchandise. The greater availability of gold will, in this case as in any
other, call out an even greater abundance of merchandise. Price rises are
always the result of a scarcity of goods, never of a greater availability of
gold.
A
bumper crop is often considered a disaster by producers who blame it for the
collapse of prices. But prices need not collapse under a gold standard. The
cash crop is part of social circulating capital and, when available in great
abundance, marginal productivity will be lowered and the discount rate fall.
New products made of the same old ingredient will appear on the shelves.
Furthermore, exporters will take advantage of the lower discount rate. They
draw bills on the bumper crop in shipping it to foreign destinations. Far
from slashing prices, the gold standard will increase market share
through slashing the discount rate. Everybody benefits.
LEGAL TENDER BANK NOTES
Scarcity
of goods is usually brought about by the banks and the government through
their interference with the free flow of gold to the bill market and with the
free flow of merchandise across international boundaries. An example of the
former is the world-wide inflation of 1896-1914, mistakenly blamed on the
increase in gold production after the opening of the mines in the Transvaal.
The prodigious increase in gold production did not cause price increases per
se. The new gold should have been allowed to flow to the bill market. It
wasn’t. Banks intercepted it in order to construct a credit pyramid
upon their greatly expanded gold reserves.
The
bank credit, however, was not healthy. It was not of the self-liquidating
kind, as it would have if it had been based on real bills drawn on goods
moving fast enough to the final gold-paying consumer. Worse still,
governments discouraged gold coin circulation instead of encouraging it. They
drove gold coins into the banks. Laws originally barring the bank of issue
from discounting financial and treasury bills were changed. The note issue
was made legal tender. This event was the salvo heralding the destruction
of the bill market. Within five years, by the time the war broke out, the
portfolio of the banks of issue consisted of financial and treasury bills,
where previously only real bills were eligible as reserves for the note
issue. The bill market was paralyzed. It has never been allowed to make a
recovery.
A
direct consequence of the unhealthy credit expansion was inflation
world-wide, even before the war. It was conveniently explained away by the
quantity theory of money, using gold as the whipping boy. Nobody pointed out
that the expansion of bank credit has far outstripped the increase in the
stock of monetary gold. Still more serious was the undermining of the
international bill market. It could no longer prevent price rises through the
discount rate mechanism, since bank reserves have been diluted through the
discounting of fiduciary and treasury bills that, unlike real bills, would
not mature into consumer goods. The fact remains that, in spite of government
propaganda, it was not the inflow of new gold but the subversion of the bill
market that caused the 1896-1914 inflation and price rises.
Economists
are guilty of failing to point out that making bank notes legal tender has
been tantamount to dethroning the sovereign consumer. It was a destructive
act. The gold coin cannot be substituted, the dictum of Mises
notwithstanding, by legal tender bank notes in its role as the regulator
whereby consumers direct production. Legal tender confers absolute and
unlimited power on the bank of issue. It is a great error indeed to classify,
as Mises does, legal tender bank notes a present
good with which consumers allegedly continue to guide production even after
the recall of gold coins from circulation. Legal tender means that the power
of consumers to decide which items to produce and which ones to discontinue
is fatally compromised. This power is now usurped by the bank of issue. Only
one economist, Professor Heinrich Rittershausen of
Germany, realized the destructive nature of the 1909 decision to make bank
notes legal tender. Unfortunately, his cry has remained, to this day, a cry
in the wilderness.
PLUNDER, THE REAL CAUSE OF INFLATION
We
have seen that the 1896-1914 inflation was not due to the sudden increase in
gold production, but to the hijacking of gold on its way to the bill market
by banks hell-bent to build unsound credit on their greatly expanded gold
reserves. The point is that this credit expansion was not matched by emerging
consumer goods because it was the result of discounting financial and
treasury bills, rather than real bills. Had it been, no inflation would have
ensued. In the actual case credit expansion made consumer goods scarce.
Prices rose as a consequence.
Going
further back in time we may observe that the great historic tides of prices,
originally blamed on gold, were really caused by military conquest and
plunder as they made goods scarce. This was true of the sack of Persepolis by
Alexander the Great in 331 B.C., as well as the sack of Cuzco by Pizzaro in 1533 A.D. The fact that looted gold was the
instrument whereby goods were made scarce in other parts of the world does
not change the validity of this observation. It was not the greater
availability of gold per se, but the scarcity of goods due to plunder, that has made prices to rise.
FALL OF THE GOLD STANDARD
The
fall of the gold standard can only be understood in the context of the
deliberate destruction of the bill market. After World War I the victorious
governments in redrawing international boundaries would not allow the free
circulation of real bills and consumer goods to resume. They did not want
free trade. They wanted autarky. They also wanted to deny the gold coin to
“man’s greedy little palms”, to use the cherished phrase
of Lord Keynes. The bill market was scuttled. Governments assumed control of
foreign trade in consumer goods, which was thereafter animated by political
rather than economic considerations.
This
turned out to be the most disastrous public decision in peacetime. In an
earlier article of this series I related how it led to the collapse of the
gold standard and to unprecedented unemployment world-wide, as predicted by Rittershausen in 1930. It is a shameless lie that the
gold standard collapsed because of its inner contradictions, after spreading
unemployment in the world. The truth is that the gold standard was destroyed
through deliberate sabotage. Legal tender bank notes made the bill market
brain-dead. Bills drawn on maturing goods no longer reflected the will of the
consumers. They reflected the will of the bank of issue that could print bank
notes ad libitum to meet payments on real bills. We should not be
fooled by the fact that a few gold coins lingered on during and after the
war, as they did in the United States. The clearing system of the gold
standard, the bill market, has been effectively destroyed. The international
gold standard was bound to fall, too. In the post mortem it was
falsely stated that the cause of death was exhaustion due to old age. No
mention of the stab wound in the back was made, namely, the 1909 decision
declaring bank notes legal tender.
The
theory and history of the gold standard has been distorted and falsified by traitors
such as Lord Keynes who was happy to take the thirty pieces of silver offered
as reward for the betrayal. It is time to set the record straight and state
the truth: mass unemployment in the 1930's was caused by the governments
themselves. They destroyed the wage fund, however inadvertently, along with
the bill market. Detractors of real bills at the Mises
Institute must logically applaud the government hatchet job. They look at the
government decision to scuttle the international bill market with satisfaction,
as a needed “purification” purging the gold standard from its
alleged imperfections. Advocates of the 100 percent gold standard are
intellectual accomplices of the greatest job destruction of history. They
approve of the abolition of the wage fund in the consumer goods sector, a
corollary of the destruction of the bill market. You cannot have it both
ways. If you deny self-liquidating credit, then you also deny jobs financed
thereby.
IN PRAISE OF GOLD HOARDING
The
most serious charge against the gold standard, made by Lord Keynes, is that
it is “contractionist.” It
encourages gold hoarding thus contracting the stock of money, the chief cause
of unemployment. The truth, however, is that gold hoarding in the early
1930's was maliciously instigated by the enemies of the gold standard, first
and foremost among them Lord Keynes himself. They started a whispering
campaign that the national currency should be devalued to help the export
industry. This was nothing short of advocating sabotage. The disingenuousness
and hypocrisy of Keynes reminds one of the thief
crying: “Thief! Thief!”
As
an economic phenomenon, gold hoarding and dishoarding are natural and
healthy. In fact, gold hoarding is part of the mechanism that regulates the
(floor of the) rate of interest. The only way the public can prevent banks
from expanding credit is through the withdrawal of bank reserves in the form
of gold coins. Contraction of reserves is the only signal banks understand.
Jaw-boning is an exercise in futility. Banks should be prepared to pay out
their bank reserves to note holders and depositors on demand. That is what
bank reserves are for. Control over changes in the stock of money is, by the
Constitution, reserved to the people. They exercise this power through their
right to withdraw bank reserves in the form of gold coins. Gold hoarding of
the marginal bondholder sets a limit to falling interest rates. Once this
right to withdraw reserves was taken away from the people banks could, and
would, drive interest rates down below the rate of marginal time preference,
taking entrepreneurs into temptation to expand production facilities. This
would lead to overinvesting and the boom-bust cycle as explained by Mises and Rothbard.
If
the government tries to stop gold hoarding by confiscating the monetary
metal, then the propensity to hoard, instead of working through the natural
conduit of gold, would find outlet in the hoarding of other marketable
merchandise, an unnatural conduit, which is fraught with great dangers. In more
details, there is the danger of generating a runaway vibrator through
resonance between price fluctuations and interest-rate fluctuations. Therein
is the explanation for the phenomenon known as Kondratiev’s
long-wave inflation/deflation cycle to be found.
RISE OF THE GOLD STANDARD
The
gold standard shall, like the mythological bird Phoenix, rise from its ashes
when the regime of irredeemable currency foisted upon the peoples of the
world will self-destruct, as it must, after the time-bomb of ever-increasing
unpaid and unpayable debt, having reached critical
mass, goes off. The born-again international gold standard will be complete
with its natural clearing system, the international bill market.
Advocates
of the so-called 100 percent gold standard display a most profound ignorance
of monetary science when they naively think that the clearing system of the
new gold standard will consist of fleets of cargo planes flying gold around
the world to satisfy their taste for purity. There is a great urgency to have
a national debate on the burning questions how to prepare for the cataclysmic
collapse of the regime of irredeemable currency that presently threatens the
world. The government has betrayed people in keeping them in ignorance. It is
inexcusable that some self-styled advocates of sound money try to smuggle in
their own petty agenda, derailing the orderly discussion of the main issue,
the study of the operation of the gold standard in depth, including its
clearing system the bill market, and its signaling system the discount rate
(as distinct from the rate of interest).
The
second coming of the gold standard and the bill market is inevitable, despite
the charlatanism of the opponents of real bills. Their 100 percent gold
standard will be rejected 100 percent by events as they unfold.
References
Antal E. Fekete, Where Mises Went Wrong,
Financial Sense Online, September 16, 2005
Antal E. Fekete,
Unemployment: Human Sacrifice on the Altar of Mammon, Financial Sense
Online, September 30, 2005
Antal E. Fekete, Economic
Entropy, Financial Sense Online, October 9, 2005
Antal E. Fekete
San Francisco School
of Economics
aefekete@hotmail.com
Read
all the other articles written by Antal E. Fekete
DISCLAIMER AND CONFLICTS
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Copyright © 2002-2008 by Antal
E. Fekete - All rights reserved
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